Myths Associated with Closed-End Investment Company Discounts

Abstract

CLOSED-END investment companies for the most part normally sell at a discount from asset value. These discounts vary and in some time periods are quite substantial. Such a discount pattern contrasts with mutual funds which sell at asset value plus a sales commission, ranging in many cases from 6% to 8%C/c. This article contends that where a closed-end investment company has a satisfactory performance record there is no mathematical or logical rationale for such a discount characteristic. The discounts are primarily the result of a lack of sales effort and public understanding. A CCORDING TO DEFINITION, a myth is a story attempting to account for something in nature. By myth man tries to rationalize an occurrence he cannot otherwise understand. He may do so in various ways, but normally all myths begin with a premise somehow based on fact. This premise is then woven into an invented fabric so the whole appears about as real as would normally be desired. The investment field has fostered many myths, some of which have been long-lived and even appear immortal. On this occasion I should like to prove false several of the myths attempting to rationalize discounts applied to Regulated Closed-End Investment Companies. Such discounts do not apply to mutual funds. More specifically, I refer to the discount from asset value at which most regulated closed-end investment companies normally sell. This is illustrated in the accompanying tabulation. The discount phenomenon stretches back many years in time and may well be the aftermath of deflated illusion following the Great Crash. Prior to that time, the argument was often made that in many instances, superior closed-end investment company performance warranted premiums of 50% or more. In any case, the discounts of recent years have persisted for such a time that numerous rationalizations have developed to support their existence. Some argue the side of the built-in capital gains tax payable. Some feel the discount results from the cost (applied against income) of running an investment company. Others point to the lackluster performance of certain funds in various time periods. Some feel a basic unawareness by investors of closed-end funds is the reason. Let me dispatch these one by one. Built-in-Capital Gains Liability-Myth The first rationale, the matter of unrealized capital gains, has several things to recommend it, not the least of which is general acceptance by the investment community. It also sounds vaguely analytical, which may account for some of its appeal. But beyond this, it has little to offer for a very simple reason. It is wrong. To begin with, I am sure all will agree that irrespective of the amount of unrealized appreciation in an investment company there is no actual tax liability until gains are realized. This being the case, it does not make much difference whether unrealized appreciation accounts for as much as 95% or as little as 5 % of a company's net assets as long as the gains which are realized and distributed each year are of modest pro